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U.S. CMBS Conduit Update Q3 2019: Debt Service Coverages On The Rise

Loan metrics for conduit commercial mortgage-backed securities (CMBS) reflected moderately less credit risk, on average, in third-quarter 2019, compared with the previous quarter and last year's vintage. Notably, debt service coverage ratios spiked (largely due to lower long-term interest rates), leverage was steady, effective loan counts were higher, and lodging exposure was lower.

Overview

Our required credit enhancement levels remain wide to the market, though they're tightening

S&P Global Ratings' required 'AAA' and 'BBB-' credit enhancement levels were somewhat lower in Q3, and the gap between our levels and market levels tightened at both points in the capital stack (see table 1). Our 'AAA' level was just north of 23%, versus a market figure of 20.5%, and our 'BBB-' level was about 10%, compared with a market average around 7%. Though exceptions may exist, we maintain the general view that about 7.0% credit enhanced 'BBB-' classes could prove vulnerable if three or four top 10 loans default and incur moderate losses, or if only one or two top 10 loans incur severe losses, especially given the relatively more concentrated nature of CMBS 2.0 conduit pools (i.e., pools in transactions issued post credit crisis).

Table 1

Summary Of S&P Global Ratings-Reviewed Conduits
2016 2017 2018 Q1:19 Q2:19 Q3:19
No. of transactions reviewed 40 48 42 10 11 14
No. of transactions rated 3 10 19 5 6 11
Average deal size (mil. $) 856 930 915 859 846 1,000
Average no. of loans 51 49 50 49 47 53
Weighted averages
S&P Global Ratings' LTV (%) 91.3 89.1 93.6 91.7 93.1 93.0
S&P Global Ratings' DSC (x) 1.7 1.8 1.8 1.7 1.8 2.0
Final pool Herf/S&P Global Ratings' Herf 25.4/36.0 26.3/34.9 28.1/36.3 27.9/34.4 25.4/34.5 28.4/35.6
% of full-term IO (final pools) 33.0 46.6 51.7 53.4 59.1 62.4
% of partial IO (final pools) 33.9 28.4 26.2 30.5 21.6 20.0
S&P Global Rating's NCF haircut (%) (10.8) (11.9) (13.0) (12.9) (13.4) (13.9)
S&P Global Ratings' value variance (%) (32.1) (33.0) (35.3) (35.3) (35.3) (35.6)
'AAA' actual/S&P Global Ratings CE (%)(i) 23.0/25.6 21.2/23.5 21.0/26.0 21.3/26.1 20.4/26.6 20.5/23.1
'BBB-' actual/S&P Global Ratings CE (%)(i) 7.8/10.2 7.1/9.3 7.1/10.9 7.3/10.7 6.8/11.5 7.0/10.2
(i)S&P Global Ratings' CE levels reflect results for pools that we reviewed. Actual CE levels represent every deal priced within a selected vintage or quarter, not just the ones we analyzed. LTV--Loan-to-value. DSC--Debt service coverage. IO--Interest-only. NCF--Net cash flow. CE--Credit enhancement.

The 14 transactions that priced in the second quarter comprised an average of 53 loans with top-10 loan composition averaging 50%. Additionally, many transactions contain top 10 loans that are larger in percentage terms than the 'BBB-' credit enhancement level. Should those loans experience difficulty and above average losses, the lower-rated classes could quickly experience high losses.

Credit quality varies broadly between transactions

We continue to observe considerable variance among deals' credit quality. Among the 11 deals we rated in the third quarter, the S&P Global Ratings loan-to-value ratio (LTV) range spanned more than 16 percentage points (from approximately 83% to 99%) and our 'AAA' required credit enhancement sported a range of more than 13 percentage points.

Conduit deals priced during third-quarter 2019 had roughly flat LTVs and much higher DSCs than those priced in the second quarter. The average LTV was 93.1%, still somewhat lower than the full-year 2018 number of 93.6%. Average DSC was 2.01x, up from 1.75x last quarter. This is likely a reflection of lower interest rates on the underlying collateral, which decreased to 4.13% this quarter from a weighted average of 4.74% in the deals we reviewed last quarter, but may also partly reflect a modest increase in full-term interest-only (IO) percentage. For the purposes of our analysis, we utilize the DSC after the partial IO period ends when analyzing those types of loans; however, partial IO percentages were actually down somewhat during the quarter.

Interest-only lending

Along those lines, overall IO percentage rose somewhat in Q3, to 82%, from 81% in Q2. The latest figure reflected a bump in full-term IO loans (up 330 basis points [bps] quarter over quarter), but a decline in partial-term loans (down 160 bps quarter over quarter). We also saw two deals this quarter with full-term IO percentages above 80%; the previous high had been around 77%.

We make negative adjustments to our loan-level recovery assumptions for all IO loans and, in some conduit transactions, we make additional pool-level adjustments when we see very high IO loan concentrations or when we see an IO loan bucket that has no discernible difference in LTV (i.e., not "pre-amortized"). The average LTV for full-term IO loans reviewed during the quarter was 90.3% (89.6% in rated transactions)--280 bps below the overall average (350 bps below the average for rated deals).

In our June 2018 deep dive into the performance of IO loans (see "IO! IO! How High Will Full-Term Go?," June 8, 2018), we found that the risk associated with IO lending is partly mitigated when loans have been pre-amortized. However, we have now started seeing deals where the weighted average LTV for the IO loans is higher than for the deal overall, which is concerning. To the good, some 56% of the collateral in the deals we rated in Q3 was from what we define as primary (versus secondary or tertiary) markets, compared with about 38% in deals we reviewed but did not rate (based on initial pools we appraised). As we noted in that same IO article, we observed during the last economic cycle that commercial real estate fundamentals/valuations rebounded more quickly in primary markets than in secondary and tertiary locations. While there is no guarantee that history would repeat itself should asset prices take a turn for the worse, all else being equal, we still consider loans backed by properties in primary locations to hold less risk.

Loan count/size metrics

Effective loan counts (or Herfindahl scores, which measure concentration or diversification by loan size) rose by three, to 28.4, in Q3 quarter over quarter. We consider this level to be well diversified, meaning that additional increases in the measure would result in only small marginal benefits to credit enhancement. The average deal size increased by over $150 million to about $1 billion, while the average number of loans rose to 53 from 47 in Q2.

An Increase In Fee/Leasehold Splits Raises A Concern

We've seen an uptick in fee/leasehold splits, where a borrower owns both interests and allocates debt accordingly. We are concerned when the sum of the debt allocated between the fee and leasehold interests is greater than what would typically be placed on a fee simple interest, resulting in a situation where the sum of the parts is greater than the original whole. In instances where we are not provided all of the relevant facts (i.e., the original fee purchase price and then the subsequent leased fee and leasehold interest values) or have concerns about the non-arm's-length nature of a transaction, we increase our stressed refinancing rates on the ground fee interest or the cap rates on the leasehold interest. In some cases we have done a "look-through" approach, where we collapse the ground lease and apply our recovery thresholds, because we feel the property's net cash flow may not support the ground rent payment with enough cushion or over the long run.

Property Type Review

Lodging falls back

Lodging exposure, which has been in a 13%-17% quarterly range since the beginning of 2017, came in at 12% in third-quarter 2019, down from 15% in the second quarter. Lodging's presence has also fallen in standalone deals this year. This may be a consequence of declining revenue per available room (RevPAR) growth overall, including declines in many top markets. Indeed, the RevPAR figure stands at +1.2% for the year according to STR, with gains in average daily room rate driving substantially all (+1.1%) of the total increase, and occupancy (+0.1%) nearly flat. This is down from about 3% growth in the metric during 2018. Smaller markets have driven the year-to-date RevPAR increase, posting 2.2% growth, while the top 25 locations overall notched a modest 0.4% decline. Some 13 of the top 25, including many of the largest markets (e.g., New York, Washington D.C., Chicago), have experienced year-over-year declines thus far in 2019.

Retail and multifamily rise, while office and industrial slip

Retail exposure rose somewhat, to 23%, in Q3, bucking the recent trend (it had fallen for three consecutive quarters before this one). Still, it remains below the 25% and 30% prints in Q1 2019 and Q4 2018. Meanwhile, multifamily rose slightly, to 12% from 11%, and the 2019 year-to-date exposure (13%) remains above the 2018 full-year figure (11%). Office remains no. 1 at 33%, down slightly from 35% last quarter, although mixed-use properties rose to 7% from 5%. Industrial slid a bit following recent increases, to 6% from 9%, although the year-to-date average of 7% is flat with last year.

image

Suburban office exposure advances again

The percentage of offices classified as suburban that we reviewed increased to 53% in Q3, from 50% in Q2, from 44% in Q1. We consider suburban offices to be more risky based on re-tenanting risk, which can be exacerbated by single-tenant exposures (or when one tenant accounts for most of the rental income). In some cases, these risks are mitigated by structure (i.e., reserves, triggers, hyper-amortization via anticipated repayment date provisions); however, in many cases, we are seeing co-terminous leases and loans, and other concerning trends.

In "Go With The (Net Cash) Flow: Correlation Between Margins And Unemployment In U.S. CMBS And Its Impact On Property Subtype Performance," Nov. 30, 2017, we noted that suburban office loans had much higher default and loss severity rates than those of loans secured by central business district office properties. In fact, the loss given default was higher than all other property types save malls and lodging.

Originations Gaining Momentum; Stable Credit Quality Expected

Still forecasting $80 billion in 2019 new issuance

We maintain our January forecast for $80 billion in private-label U.S. CMBS issuance (excluding commercial real estate collateralized debt obligations) this year. Total issuance has picked up steam of late, and lower long-term benchmark rates should generally be supportive of higher origination volume, in our view. As of Sept. 30, we're at just over $57 billion.

Credit outlook stable despite upgrade/downgrade ratio falling below 1x

In third-quarter 2019, we downgraded 23 ratings and upgraded 10. Of the 23 lowered classes, 15 were from legacy CMBS 1.0 vintage transactions where the downgrades primarily reflect interest shortfall concerns. As the legacy transactions continue to experience performing loans paying down and special servicing assets liquidating, idiosyncratic risks increase with the advancing of delinquent assets becoming unpredictable and nonrecoverable determinations being made sooner in the process by the master servicer. The remaining eight classes downgraded were from CMBS 2.0 transactions, where some of the lowered ratings reflect an increase in special servicing loans (CSAIL 2017-CX9) or principal losses (TRU 2016-TOYS). We also raised 10 ratings in the third quarter, with five from a single-borrower transaction (GPT 2018-GPP) that experienced property releases at a release premium, resulting in credit enhancement improvement.

While the upgrade/downgrade ratio fell below 1x in the third quarter, this was primarily due to the negative rating actions on the legacy deals. For the CMBS 2.0 transactions, property-specific events continue to drive negative actions rather than any systemic change. As such, we expect overall stable credit quality for the sector over the remainder of the year and going into 2020.

Table 2

S&P Global Ratings' CMBS Rating Summary
2014 2015 2016 2017 2018 Q1:19 Q2:19 Q3:19
Upgrades 284 272 495 353 170 34 33 10
Downgrades 228 209 150 153 99 48 21 23
Upgrade/downgrade ratio (x) 1.2 1.3 3.3 2.3 1.7 0.7 1.6 0.4

Related Criteria

  • CMBS Global Property Evaluation Methodology, Sept. 5, 2012
  • Rating Methodology And Assumptions For U.S. And Canadian CMBS, Sept. 5, 2012

Related Research

  • U.S. CMBS Conduit Update Q1 2019: Loan Metrics Improve As Steady Conditions Prevail, April 4, 2019
  • U.S. CMBS Conduit Update Q4 2018: Metrics Deteriorated A Bit, Stable Ratings Expected In 2019 With Some Caveats, Jan. 9, 2019
  • U.S. CMBS Conduit Update Q3 2018: Metrics Mostly Improve Although Deal Dispersion Widens Again, Oct. 4, 2018
  • U.S. CMBS Conduit Update Q2 2018: Credit Quality Variances Are On The Rise As Loan Structural Features Weaken, July 5, 2018
  • U.S. CMBS Conduit Update Q1 2018: Interest-Only Loan Volume And LTVs Remain High, April 2, 2018

This report does not constitute a rating action.

Primary Credit Analyst:Senay Dawit, New York + 1 (212) 438 0132;
senay.dawit@spglobal.com
Secondary Contact:Rachel Buck, Centennial + 1 (303) 721 4928;
rachel.buck@spglobal.com
Global Structured Finance Research:James M Manzi, CFA, Washington D.C. (1) 434-529-2858;
james.manzi@spglobal.com

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